• An exchange-traded fund or "ETF" is an investment product representing a diverse group of assets such as stocks, bonds, etc.
  • Unlike mutual funds, ETFs can be bought and sold over public stock exchanges and may even occasionally trade at a discount relative to their NAV.
  • ETFs may be purchased using a taxable brokerage account or a tax-advantaged retirement savings account (if allowed by the plan administrator).

What if you could take the best attributes of a mutual fund and combine it with those of a stock? The result would be an entirely unique type of investment product called an ETF.

Here's what you need to know about ETFs and how they may help benefit your financial future.

What is an ETF?

An ETF or "exchange-traded fund" is a security representing a collection of assets such as stocks, bonds, and other investments. Like a mutual fund, it offers a practical way to diversify across the market and fine-tune your investment strategy to include certain asset classes or sectors. This enables you to easily gain exposure to securities or investment strategies that you might not normally use.

At the same time, ETFs are also similar to stocks in that they trade over public stock exchanges during normal market hours. This may provide you with increased liquidity, the opportunity to acquire shares at a discount, and better tax efficiency.

How Do ETFs Work?

Since their introduction in the 1990s, ETFs have become a popular financial instrument among the investment community. Here's what you need to know about their inner workings and how it can help your portfolio.

Structure of an ETF

As with mutual funds, an ETF is its own legal entity (i.e., usually as a registered investment company) that holds assets on behalf of its shareholders. When you buy a share of an ETF, you own a piece of the company but are not directly entitled to any of the investments it holds.

Many ETFs are passively constructed to follow a broad market index such as the S&P 500 or NASDAQ. However, some are actively managed ETFs where a professional fund manager is appointed to make decisions about their investment strategy and which assets to buy and sell.

Net Asset Value

Many people choose to use ETFs as long-term investments. As the value of its underlying assets may increase, so too does its market price or NAV.

NAV stands for “net asset value" and represents the net worth of the fund (i.e., assets minus liabilities) divided by the number of shares.[1] As the NAV rises, you may have the opportunity to sell your shares at a higher price than what you originally paid and reap the earnings.

Earning Money with ETFs

Because ETF shares trade in the open market, the share price will be influenced by supply and demand. Therefore, the share price could deviate from the NAV, creating unique buying and selling opportunities throughout the trading day.

Another way to make money from ETFs is through distributions such as dividends. Dividends are occasional earnings or capital that the fund returns to its shareholders. These payments might be distributed on a quarterly or monthly basis.

Contrary to mutual funds, ETFs do not typically distribute capital gains to their shareholders. This may be more convenient for your taxes when preparing your federal return.

Expense Ratios

ETFs carry an annual fee called an expense ratio. This is the cost the fund is charging you expressed as a percentage of NAV. For example, an ETF with a 0.1% expense fee would charge $10 for every $10,000 invested. These fees are usually automatically deducted daily from the fund's NAV rather than appearing as separate charges.

Types of ETFs

ETFs come in all shapes and sizes, each with its own investment strategy and objectives. The following are some of the most commonly used types.

Index ETFs

Index-based ETFs are designed to replicate the performance of a broad market benchmark. The indices targeted are often focused on commonly traded asset classes like large-cap stocks or U.S. Treasury bonds.

Examples:

  • SPDR S&P 500 ETF Trust (SPY): One of the oldest ETFs that tracks the S&P 500 stock market average, a commonly followed equity benchmark consisting of the 500 leading U.S. companies.
  • Vanguard Total Bond Market ETF (BND): Tracks the Bloomberg US Aggregate Bond Index, a benchmark index representing the U.S. investment-grade fixed-income market.

Sector ETFs

Sector ETFs target specific types of businesses or markets. These might be new kinds of energy or technology, healthcare, precious metals, etc.

Example:

  • VanEck Vectors Semiconductor ETF (SMH): Tracks the market-cap-weighted index of the 25 largest US-listed semiconductor companies.

Synthetic ETFs

Rather than holding actual assets like stocks or bonds, synthetic ETFs invest in financial derivatives to replicate their performance. This may be done using contracts such as options, futures, swaps, etc.

Example:

  • BlackRock iShares S&P 500 Swap (UCITS): Replicates the S&P 500 index by entering into unfunded total return swaps with counterparties.

Leveraged ETFs

Leveraged ETFs borrow money or utilize financial derivatives in an attempt to amplify the returns of an underlying index or asset. This may lead to greater earnings potential but also poses a higher risk of loss.

Example:

  • ProShares Ultra S&P500 (SSO): Seeks to produce double the daily performance of the S&P 500

Inverse ETFs

Inverse ETFs are designed to move in the opposite direction of an underlying index or asset. They're often used to profit from a market decline or hedge against losses by betting against the performance of a specific index.

Example:

  • Simplify Volatility Premium ETF (SVOL): Provides a return that corresponds to approximately one-fifth to three-tenths (-0.2x to -0.3x) the inverse of the Chicago Board Options Exchange's (CBOE) Volatility Index (VIX) short-term futures index.

How To Invest in ETFs

ETFs are fairly commonplace, and many investors find trading them to be a relatively straightforward process. To add them to your portfolio, consider the following steps.

1) Define your Financial Goals

Ask yourself: What do I plan to do with the money once it's invested? Will it be for later in life (such as retirement), or for goals that are more near-term (such as a down payment on a house)? This question is important because it may dictate which type of account you use and the investments you select.

2) Choose an Account Type

For building long-term wealth, a tax-sheltered retirement savings account such as an IRA or 401(k) may be best suited. Please note that not all employer-sponsored plans allow participants to purchase ETFs. To be sure, please contact your plan administrator.

For goals that are more short-term, a taxable brokerage account or investment service provider might be a better fit. This can provide you with the ability to liquidate your funds as needed for your upcoming purchase.

3) Select your ETFs

Your investment selections should be chosen based on your desired return targets and tolerance for risk. For example, stock-based ETFs with an average amount of risk are generally good for long-term investors because they can ride out short-term market fluctuations.

4) Regularly Make Contributions

If your account allows it, you may find it beneficial to have it automatically purchase more ETF shares every one to four weeks. This strategy will take advantage of a technique known as "dollar cost averaging," which involves investing at regular intervals, regardless of market price, to acquire securities at a discount and smooth out volatility.[2]

5) Monitor the Performance

Periodically review the performance of your portfolio. If any ETFs aren't aligning with your financial objectives, then consider swapping them out for alternative selections. Don't forget to also consider rebalancing your portfolio once per year.

Pros and Cons of Investing in ETFs

ETFs have a lot of great benefits to offer investors. However, they're not always the best choice in some instances. For these reasons, please consider the following pros and cons.

Advantages of Using ETFs for Investing

  • Investment Convenience - ETFs can serve as a one-stop shop for purchasing a larger, diverse range of assets or those with unique investment strategies.
  • Variety - Whether you're looking for a simple ETF that follows a stock market index or a synthetic one utilizing more complex instruments such as derivatives, there's generally an option available.
  • Low expense ratios - ETFs often cost less than mutual funds with similar characteristics. Lower expenses mean more profit for you.
  • Liquidity - Because ETFs can be freely sold over open stock market exchanges, trading shares can usually be done right away.
  • Tax efficiency - By design, ETFs don't return capital gains to their shareholders the same way that mutual funds do. That means fewer tax complications when you file your federal income tax return.
  • Transparency - Publicly traded ETFs are required to disclose important characteristics about the fund. This information can be found in the prospectus, a legal document that provides detailed information about the fund, such as its investment objectives, historical returns, risks, and expenses.

Potential Downsides of ETFs

  • Market Risk - Like many other investments, ETFs can lose money due to unfavorable market conditions or poor fund management. Investors should be aware of this possibility and take the ETF's investment strategy into consideration before committing any capital.
  • Sector Risk - While the overall market may be doing well, some specific sectors may be subject to their own unique risks and underperform.
  • Complexity - Some ETFs have more complex investment strategies than others. Before purchasing shares, it's good practice to review the prospectus and make sure you align with its methods.
  • Tracking Errors - Although index funds closely mirror benchmarks, discrepancies in their performance may still occur, or even errors.
  • Trading Costs - If you use a financial platform that charges commissions, you may incur additional costs for buying and selling shares.
  • Tax Complications - Depending on the ETF's underlying assets and investment strategy, some uncommon taxes may be triggered. An example would be an ETF that invests in foreign companies or holds foreign stocks. Review the prospectus before purchasing shares.

Differences Between ETFs vs. Mutual Funds

Although ETFs share many similarities with mutual funds, there are some distinct differences. The following are a few key points to consider as you assemble your portfolio.

Inception

Mutual funds have been a part of the investing industry significantly longer than ETFs. The first mutual fund, the Massachusetts Investors Trust (MIT), began in 1924.[3]

By contrast, the first ETF was introduced in Canada in 1990. Three years later, the U.S. followed up with its own ETF debut: the SPDR S&P 500 ETF Trust (SPY).[4]

Management Style

Generally, many ETFs adopt a more passive investment approach than mutual funds. However, active and passive options of both types of securities do exist.

Expense Ratios

ETFs tend to have lower expense ratios than their mutual fund counterparts, largely due to their passive nature. Without the cost of a fund manager or additional expenses, these savings may be passed on to the shareholders.

Tax Efficiency

Distributing capital gains to shareholders is not as common for ETFs as it is for mutual funds. This can make filing your taxes easier.

Liquidity

Since ETFs trade in the open market, investors may find it easier to buy and sell shares than those of mutual funds.

Minimum Investment

Mutual funds often require a minimum amount to start investing (such as $1,000 or more). By contrast, because ETFs may be bought as fractional shares, the minimum required could be as little as the limit set by the brokerage you're using.

Final Thoughts

Exchange-traded funds are a practical way to invest in a broad market index or diversify into specific investments and sectors. Although they share a lot of similarities with mutual funds, ETFs also encompass many advantages of stocks, such as being traded over open exchanges and improved tax efficiency.

Like most investments, ETFs are subject to market risk and may occasionally lose value. Some might also utilize complex investment strategies, which may amplify losses under certain economic conditions. Investors should evaluate their options thoroughly and make selections utilizing those funds which align with their financial goals and tolerance for risk.